Management Techniques Utilized by Warren E. Buffett
“To invest successfully over a lifetime does not require stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for decisions and the ability to keep emotions from corroding that framework”- Warren Buffet.
Warren Edward Buffett is a successful American investor, businessman and a philanthropist from Omaha, Nebraska. He is the world’s greatest investor and has made an enormous fortune from astute investments, particularly through the company Berkshire Hathaway, of which he is the largest shareholder and CEO.
He is know as the Oracle of Omaha and has always outclassed the market at all times.
He is ranked by Forbes as the second-richest person in the world, after Microsoft co-founder Bill Gates. Despite being wealthy, Buffett leads a simple and a frugal lifestyle.
Warren Buffett has been influenced by Benjamin Graham, who taught him and coached him. Other future value investors like Walter Schloss and Irving Kahn also influenced Buffett.
Another influence on Buffett’s investment philosophy was the well known investor and writer Philip Fisher.
Initially, based on Graham’s principles, Buffett used a three-pronged approach to investing in stocks:
1. He chose those undervalued securities / stocks that possessed margin of safety and met expected return-to-risk characteristics.
2. Moreover, he chose companies whose events were not related to broader market changes, such as mergers and acquisitions, liquidation, etc.
3. Finally, he built sizeable holdings, allied with other shareholders or employed proxies to effect changes in companies.
Buffett began purchasing shares of a large manufacturing company in the declining textile industry, Berkshire Hathaway, which was a mistake due to the failure of the textile industry. However, Berkshire became one of the largest holding companies in the world as Buffett began to acquire private businesses and invest in the stocks of public companies.
Buffett’s investment approach changed and he began to focus on high-quality businesses with enduring competitive advantages which kept rivals at a safer distance such as Coca – Cola. This investment strategy is used by Berkshire Hathaway, especially when acqui9ring companies, rather than the stocks. As a result, the company now owns a large number of businesses which are dominant players in their industries and specialize in various niche markets, or possess unique characteristics which differentiates them from their competitors.
When Buffett acquires any business, he only takes the responsibility of allocating capital to businesses with good economics and lets them keep their existing management to lead the company; he does not interfere with the running of the company. However, he takes the responsibility for hiring and setting the compensation of the top executive besides allocating capital to the businesses that give high returns. Not only Buffett is skillful in managing Berkshire’s cash flow, but also in managing the company’s balance sheet. He takes all the decisions based on their effect on the balance sheet.
Portfolio management – Investment Approach
Warren Buffet has a very unique style of managing portfolios, a method which he has dubbed “focus investing”. Buffett’s philosophy on investing is a modification of the value investing approach of his mentor Benjamin Graham.
Portfolio management is basically a method of managing assets, which may be securities, in such a manner that the investor is able to earn maximum return and minimize his risk. “The aim of Portfolio Management is to achieve the maximum return from a portfolio which has been delegated to be managed by an individual manager or financial institution. The manager has to balance the parameters which define a good investment i.e. security, liquidity and return. The goal is to obtain the highest return for the client of the managed portfolio.” (www.citibank.com/bahrain/gcb/invest/glossary.htm)
“Focus investing” is a cornerstone of Buffet’s success. There are many investors who think about the next minute, day or month and are frantic watch screens. Buffet says that the investors need to be clam and think in years and not on minutes, days or months. Buffet says: “We just focus on a few outstanding companies. We’re focus investors.”
Moreover, Buffet advices on focusing on only fewer companies for investment purposes. That way, the investor will not have to monitor so many companies at the same time. Therefore, “focus investing” investment approach greatly simplifies the task of portfolio management.
Some of the investors constantly monitor their stocks and take actions according to their predictions. This is the active approach to investing. Whereas others do index investing, which is a buy-and-hold passive approach. “It involves assembling, and then holding, a broadly diversified portfolio of common stocks deliberately designed to mimic the behavior of a specific benchmark index, such as the Standard & Poor’s 500. The simplest and by far the most common way to achieve this is through an indexed mutual fund.”
“Active portfolio management as commonly practiced today stands a very small chance of outperforming the index. For one thing, it is grounded in a very shaky premise: Buy today whatever we predict can be sold soon at a profit, regardless of what it is. The fatal f law in that
logic is that given the complexity of the financial universe, predictions are impossible. Second, this high level of activity comes with transaction costs that diminish the net returns to investors. When we factor in these costs, it becomes apparent that the active money management business has created its own downfall.”
On the other hand, indexing is a relatively better approach in managing portfolios. However, this approach cannot guarantee maximum returns since it will average out all the returns in the portfolio and will only net you exactly the returns of the overall market. Index investors can do no worse than the market, and also no better.
Intelligent investors must ask themselves if they are satisfied with average or if they can do better.
Warren Buffet favors the indexing approach to active investing. This approach is preferred by investors who have a “very low tolerance for risk, and who know very little about the economics of a business but still want to participate in the long-term benefits of investing in common stocks.”
However, Buffett advices to do focus investing, which yields even better results than indexing.
Focus investing means choosing a “few stocks that are likely to produce above-average returns over the long haul, concentrating the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.”
Warren Buffett’s five golden rules for using the focus investing approach are as follows:
“1. Concentrate your investments in outstanding companies run by strong management.
2. Limit yourself to the number of companies you can truly understand. Ten to twenty is good, more than twenty is asking for trouble.
3. Pick the very best of your good companies, and put the bulk of your investment there.
4. Think long-term: five to ten years, minimum.
5. Volatility happens. Carry on.”
First, Warren Buffet advises to choose outstanding companies. “If the company is doing well and is managed by smart people, eventually its stock price will reflect its inherent value.” Hence, Buffet advises not to devote attention to tracking share price but to analyzing the economics of the underlying business and assessing whether its management is strong enough or not. Then the investor needs to isolate companies that have a long history of superior performance, which means increasing profits, and a stable management. This approach is for those investors who understand the science of investing and the economics business. The investors should concentrate on ten to twenty companies only that they have identified.
Moreover, Buffet is in favor of making large investments only when the opportunity to earn higher returns is there. He says that “With each investment you make, you should have the courage and the conviction to place at least ten percent of your net worth in that stock.”
In addition to this, focus investing approach requires patience and commitment. It means putting meaningful amounts of money in a few things and not having a very large diversified portfolio. This differentiates it from the indexing approach. He advises the investors to patiently hold their portfolio even when it appears that other strategies are winning. Therefore, his approach is to hold the stocks for a longer period. Holding stocks for a longer period are also beneficial in USA because if the stocks are sold, there are taxes levied on the capital gains. Hence, holding for a longer period and not selling it will have tax benefits.
Also, Warrant Buffett advises to hold the portfolio for over than five years so that the capital gains are higher when the companies’ stock prices increase considerably after a long time. The goal is to avoid zero turnover. “As a general rule of thumb, we should aim for a turnover rate between 20 and 10 percent, which means holding the stock for somewhere between five and ten years.”
Focus investing pursues above-average results even though the price volatility is high. The focus investors should tolerate the price volatility because “in the long run the underlying economics of the companies will more than compensate for any short-term price fluctuations.” Therefore, the investors should ignore the price changes and should not panic. Price changes are reflective of the efficient markets where the information is easily available to all the investors. This is the Efficient Market Theory.
Price volatility defines risk. However, to Buffet it is an opportunity to make money. He says that a decrease in the price actually reduces risk. “Buffett has a different definition of risk: the possibility of harm. And that is a factor of the intrinsic value of the business, not the price behavior of the stock. Financial harm comes from misjudging the future profits of the business, plus the uncontrollable, unpredictable effect of taxes and inflation. Furthermore, Buffett sees risk as inextricably linked to an investor’s time horizon.”
Decreasing the time period of holding the stock increase the risk of losing, whereas if you extend your time horizon, then the odds shift meaningfully in your favor and this reduces the risk and increases the chances of higher returns.
Also, Warren Buffet is of the view that diversification is risky. He says that the purpose of diversification is to reduce price volatility. However, according to his rule of ignoring price volatility, diversification doesn’t really matter. Having diversified portfolio makes it hard for the investor to study the business and monitor it. However, having concentrated portfolio makes it easy for the investor better able to study the companies closely and understand their intrinsic value. The more knowledge you have about your company, the less risk you are likely taking.
Warren Buffet is not against diversification but he says that it is for a person who does not know about the economics of the business and does not want to study the companies. Since, the fo9cus investor is knowledgeable; he will not go for diversified portfolio.
Moreover, focus investor should not become a slave to the stock market’s whims, but should always be acutely aware of all economic happening in the companies in the portfolio. Hence, he will not make changes to the portfolio that he has made in the first place.
“When Buffett considers adding to or purchasing an investment, he first looks at what he already owns to see whether the new purchase is any better. If the new investment does not increase the value of the portfolio, then it should not be considered.
Most importantly, Buffet does not invest in the technology stocks such as Microsoft or Hewlett-Packard due to their instability and volatility. He does not invest in companies whose balance sheet does not look stable in the future.
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